2
2/19 Motivation Framework Data Regressions Portfolio Sorts Conclusion Motivation Equity option market is big and grows very fast  Most option research focuses on pricing options relative to the underlying stock, given the stock price  But not much is known about the returns investors can expect to receive from holding various stock options We examine the cross-sectional determinants of expected equity option returns  Focus on the role of volatility  Study delta-hedged options (control for the price movement of underlying stocks), which are most sensitive to volatility risk  Use a large sample of individual stock options rather than index options

4
4/19 Motivation Framework Data Regressions Portfolio Sorts Conclusion Daily Rebalanced Delta-Hedged Gains Delta-hedged gain: following Bakshi and Kapadia (2003a)  Changes in the value of a portfolio of a long call position, and hedged by a short position in the underlying stock, with the net investment earning risk-free rate Discrete version: daily rebalancing for empirical analysis Normalized: the gain is scaled by stock (or option) price

18
18/19 Motivation Framework Data Regressions Portfolio Sorts Conclusion Economic Interpretations of Negative Risk Premium Compensation for option sellers  Volatility premium could be compensation for option sellers who are unable to eliminate volatility risk through hedging and diversification  Even if they could perfectly hedge the option’s exposure to underlying stock, they are exposed to volatility risk, which are higher for more volatile stocks Options on high volatility stocks are overvalued  These options attract investors who like to gamble or who prefer positive skewness in payoffs  Overconfident investors overreact to recent increase in volatility of these stocks

19
19/19 Motivation Framework Data Regressions Portfolio Sorts Conclusion Conclusion This paper provides a comprehensive study of individual option returns, after delta-hedging their exposure to the underlying stock returns The average delta-hedged stock option returns are negative These returns decrease with the volatility of the underlying stock. The result is driven by idiosyncratic volatility Individual stock options embed a negative premium for the underlying stock’s stochastic volatility This premium could be compensation for option sellers, or reflect the overvaluation created by option investors